Financial Statements

Financial Statements
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P1 Identify and prepare basic financial statements and explain how they interrelate.

This section shows how financial statements are prepared from the analysis of business transactions. The four financial statements and their purposes are:

Income statementFinancial statement that subtracts expenses from revenues to yield a net income or loss over a specified period of time; also includes any gains or losses.—describes a company’s revenues and expenses along with the resulting net income or loss over a period of time due to earnings activities.
Statement of retained earningsReport of changes in retained earnings over a period; adjusted for increases (net income), for decreases (dividends and net loss), and for any prior period adjustment.—explains changes in retained earnings from net income (or loss) and from any dividends over a period of time.
Balance sheetFinancial statement that lists types and dollar amounts of assets, liabilities, and equity at a specific date.—describes a company’s financial position (types and amounts of assets, liabilities, and equity) at a point in time.
Statement of cash flowsA financial statement that lists cash inflows (receipts) and cash outflows (payments) during a period; arranged by operating, investing, and financing.—identifies cash inflows (receipts) and cash outflows (payments) over a period of time.

1-2

We prepare these financial statements using the 11 selected transactions of FastForward. (These statements are technically called unadjusted—we explain this in Chapters 2 and 3.)

Income Statement

Point: Net income is sometimes called earnings or profit.

Point: Decision makers often compare income to the operating section of the statement of cash flows to help assess how much income is in the form of cash.

FastForward’s income statement for December is shown at the top of Exhibit 1.10. Information about revenues and expenses is conveniently taken from the Equity columns of Exhibit 1.9. Revenues are reported first on the income statement. They include consulting revenues of $5,800 from transactions 5 and 8 and rental revenue of $300 from transaction 8. Expenses are reported after revenues. (For convenience in this chapter, we list larger amounts first, but we can sort expenses in different ways.) Rent and salary expenses are from transactions 6 and 7. Expenses reflect the costs to generate the revenues reported. Net income (or loss) is reported at the bottom of the statement and is the amount earned in December. Stockholders’ investments and dividends are not part of income.

Exhibit 1.10	Financial Statements and Their Links

Point: A statement’s heading identifies the company, the statement title, and the date or time period.

Point: Arrow lines show how the statements are linked. Net income is used to compute equity. Retained earnings is used to prepare the balance sheet. Cash from the balance sheet is used to reconcile the statement of cash flows.

Point: The income statement, the statement of retained earnings, and the statement of cash flows are prepared for a period of time. The balance sheet is prepared as of a point in time.

Point: A single ruled line denotes an addition or subtraction. Final totals are double underlined. Negative amounts are often in parentheses.

Statement of Retained Earnings

Point: The statement of retained earnings is also called the statement of changes in retained earnings. Note: Beg. Retained Earnings + Net Income – Dividends = End. Retained Earnings

The statement of retained earnings reports information about how retained earnings changes over the reporting period. This statement shows beginning retained earnings, events that increase it (net income), and events that decrease it (dividends and net loss). Ending retained earnings is computed in this statement and is carried over and reported on the balance sheet. FastForward’s statement of retained earnings is the second report in Exhibit 1.10. The beginning balance is measured as of the start of business on December 1. It is zero because FastForward did not exist before then. An existing business reports the beginning balance as of the end of the prior reporting period (such as from November 30). FastForward’s statement shows the $4,400 of net income earned during the period. This links the income statement to the statement of retained earnings (see line (). The statement also reports the $200 cash dividend and FastForward’s end-of-period retained earnings balance.

Balance Sheet

FastForward’s balance sheet is the third report in Exhibit 1.10. This statement refers to FastForward’s financial condition at the close of business on December 31. The left side of the balance sheet lists FastForward’s assets: cash, supplies, and equipment. The upper right side of the balance sheet shows that FastForward owes $6,200 to creditors. Any other liabilities (such as a bank loan) would be listed here. The equity (capital) balance is $34,200. Note the link between the ending balance of the statement of retained earnings and the retained earn ings balance here—see line (). (This presentation of the balance sheet is called the account form: assets on the left and liabilities and equity on the right. Another presentation is the report form: assets on top, followed by liabilities and then equity at the bottom. Either presentation is acceptable.)

Decision Maker

Answer — p. 26

Retailer You open a wholesale business selling entertainment equipment to retail outlets. You find that most of your customers demand to buy on credit. How can you use the balance sheets of these customers to help you decide which ones to extend credit to?

Decision Maker boxes are role-playing exercises that stress the relevance of accounting.

Statement of Cash Flows

Point: Statement of cash flows has three main sections: operating, investing, and financing.

Point: Payment for supplies is an operating activity because supplies are expected to be used up in short-term operations (typically less than one year).

FastForward’s statement of cash flows is the final report in Exhibit 1.10. The first section reports cash flows from operating activities. It shows the $6,100 cash received from clients and the cash paid for supplies, rent, and employee salaries. Outflows are in parentheses to denote subtraction. Net cash provided by operating activities for December is $1,000. If cash paid exceeded cash received, we would call it “cash used by operating activities.” The second section reports investing activities, which involve buying and selling assets such as land and equipment that are held for long-term use (typically more than one year). The only investing activity is the $26,000 purchase of equipment. The third section shows cash flows from financing activities, which include the long-term borrowing and repaying of cash from lenders and the cash investments from and dividends to stockholders. FastForward reports $30,000 from the owner’s initial investment and the $200 cash dividend. The net cash effect of all transactions is a $29,800 cash inflow. The final part of the statement shows FastForward increased its cash balance by $4,800 in December. Since it started with no cash, the ending balance is also $4,800—see line .

Point: Investing activities refer to long-term asset investments by the company, not to owner investments.

Quick Check

Answers—p. 26

Explain the link between the income statement and the statement of retained earnings.
Describe the link between the balance sheet and the statement of retained earnings.
Discuss the three major sections of the statement of cash flows.

Decision Analysis

Return on Assets

A3 Compute and interpret return on assets.

A Decision Analysis section at the end of each chapter is devoted to financial statement analysis. We organize financial statement analysis into four areas: (1) liquidity and efficiency, (2) solvency, (3) profitability, and (4) market prospects—Chapter 13 has a ratio listing with definitions and groupings by area. When analyzing ratios, we need benchmarks to identify good, bad, or average levels. Common benchmarks include the company’s prior levels and those of its competitors.

This chapter presents a profitability measure, that of return on assets. Return on assets is useful in evaluating management, analyzing and forecasting profits, and planning activities. Dell has its marketing department compute return on assets for every order. Return on assetsRatio reflecting operating efficiency; defined as net income divided by average total assets for the period; also called return on assets or return on investment. (ROA), also called return on investment (ROI), is defined in Exhibit 1.11.

Exhibit 1.11	Return on Assets

Net income is from the annual income statement, and average total assets is computed by adding the beginning and ending amounts for that same period and dividing by 2. To illustrate, Best Buy reports net income of $984 million in 2005. At the beginning of fiscal 2005, its total assets are $8,652 million and at the end of fiscal 2005, they total $10,294 million. Best Buy’s return on assets for 2005 is:

Is a 10.4% return on assets good or bad for Best Buy? To help answer this question, we compare (benchmark) Best Buy’s return with its prior performance, the returns of competitors (such as Circuit City, RadioShack, and CompUSA), and the returns from alternative investments. Best Buy’s return for each of the prior five years is in the second column of Exhibit 1.12, which ranges from 1.3% to 10.4%. These returns show an increase in its productive use of assets in recent years. We also compute Circuit City’s returns in the third column of Exhibit 1.12. In four of the five years, Best Buy’s return exceeds Circuit City’s, and its average return is higher for this period. We also compare Best Buy’s return to the normal return for similar merchandisers of electronic products (fourth column). Industry averages are available from services such as Dun & Bradstreet’s Industry Norms and Key Ratios and Robert Morris Associates’ Annual Statement Studies. When compared to the industry, Best Buy performs well.

Exhibit 1.12	Best Buy, Circuit City, and Industry Returns

Decision Maker

Answer — p. 26

Business Owner You own a small winter ski resort that earns a 21% return on its assets. An opportunity to purchase a winter ski equipment manufacturer is offered to you. This manufacturer earns a 19% return on its assets. The industry return for this manufacturer is 14%. Do you purchase this manufacturer?

Each Decision Analysis section ends with a role-playing scenario to show the usefulness of ratios.

Decision Analysis (a section at the end of each chapter) introduces and explains ratios helpful in decision making using real company data. Instructors can skip this section and cover all ratios in Chapter 13.

Quick Study 1-11, 1-12

Exercises 1-13, 1-14, 1-15, 1-16, 1-17, 1-18

Problems 1-3A, 1-4A, 1-5A, 1-6A, 1-7A, 1-8A, 1-9A, 1-3B, 1-4B, 1-5B, 1-6B, 1-7B, 1-8B, 1-9B, 1-10B, 1-11B

Reporting in Action, Comparative Analysis, Taking it to the Net, Global Decision

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Home > Chapter 1 > Financial Statements

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	Course-wide Content
		Study Guide Sample Cha... Working Papers Sample ... Appendices Student ALEKS Mobile Resources Net Tutor Video Library

	Instructor Resources
		Instructor Resource Ma... Solutions Manual Solutions to Excel Problem Set C Solutions More Taking it to the ...
	News, Articles & Links
		Text Company Links
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		Multiple Choice True or False
	More Resources
		Key Terms Review Chapter Glossary PowerPoint Presentations Excel Template Assignm... Business Week Articles More Taking it to the ... Problem Set C Topic Tackler Narrated Slides Video Segments iPod Content
	eBook
		Chapter Opener Importance of Accounting Fundamentals of Accoun... Transaction Analysis a... Financial Statements Demonstration Problem Appendix 1A Return and... Appendix 1B Business A... Summary Guidance Answers to De... Guidance Answers to Qu... Key Terms Multiple Choice Quiz Discussion Questions Quick Study Exercises Problem Set A Problem Set B Problem Set C Serial Problem Beyond the Numbers Answers to Multiple Ch...